Oil prices surge to become a "booster"? Amidst the flames of war, commodity currency arbitrage trading welcomes its strongest start in three years

The situation in the Middle East is impacting global assets, but forex carry trades are performing strongly against the trend, becoming one of the few standout strategies in a turbulent market.

Oil prices have surged to multi-year highs due to the conflict, benefiting commodity-exporting currencies and providing additional support for carry trades. Some strategies have seen returns exceeding 6% this year, marking the strongest start since 2023. Meanwhile, the gains in U.S. Treasury bonds have been completely wiped out, and the stock market continues to face pressure.

A carry trade strategy involving borrowing in yen and buying a basket of currencies including the Brazilian real, Colombian peso, and Turkish lira has returned over 2% since the outbreak of the conflict. Leah Traub, head of the currency team at Lord Abbett & Co, stated, the main reason for the strong performance of forex carry trades is commodities, with certain high-yield currencies directly benefiting from rising oil and gas prices.

Oil-producing countries like Brazil have become favored targets for capital. The country's benchmark interest rate is as high as 15%, combined with increasing oil production and export revenues, making it one of the preferred battlegrounds for arbitrage trading. Macquarie Group strategists noted, going long on currencies of oil-producing countries that are far from the conflict is particularly advantageous in the current environment.

However, risks cannot be ignored. Citigroup strategists closed their last recommended emerging market carry positions last week, citing the high uncertainty and volatility brought about by the conflict. Analysts warn that if risk aversion triggers a sharp appreciation of the yen, or if Japanese authorities intervene, the profits from carry trades could evaporate quickly.

Oil Prices as Key Drivers of Carry Trades

The core logic of carry trades is to borrow low-interest currencies and invest in high-interest currencies to earn the interest rate differential. In the current market environment, the trend of commodity prices is playing an increasingly important role.

"The reason forex carry trades are performing so robustly is primarily due to commodities," said Leah Traub, portfolio manager and head of the currency team at Lord Abbett & Co., which manages approximately $248 billion in assets. "Some high-carry currencies benefit from rising oil and gas prices."

In this context, traders tend to borrow currencies from countries with significant exposure to rising energy costs (like the yen) and invest in currencies of economies that benefit from energy exports. A popular combination is borrowing yen to buy a basket of currencies including the Brazilian real, Colombian peso, and Turkish lira. According to Bloomberg data, this combination has returned over 2% since the Middle East conflict began, with a cumulative return exceeding 6% this year.

Brazil as the Core Target for Carry Trades

Among emerging markets, Brazil has become the preferred target for carry traders due to its dual advantages of high interest rates and oil and gas exports.

Brazil's benchmark interest rate currently stands at 15%, and its one-month carry volatility— a key indicator of the strategy's attractiveness—remains high compared to similar economies. Legacy Capital Gestora de Recursos Ltda., a hedge fund based in São Paulo managing approximately $3 billion in assets, has been continuously positioning in the real based on this logic, funding related trades by shorting counter-cyclical developed market currencies "We maintain our existing positions," said Felipe Guerra, co-founder and Chief Investment Officer of the company.

Thierry Wizman, a strategist at Macquarie Group in New York, shares a similar view: "I would not shy away from carry trades in currencies of oil-producing countries far from conflict zones. Brazil has been continuously increasing its oil production in recent years, benefiting significantly from this."

Emerging Markets Supported by Structural Factors

In addition to oil price factors, some investors believe that the resilience of emerging market currencies has deeper structural support.

Anna Wu, cross-asset investment strategist at Van Eck Associates in Sydney, stated: "Over the past year or so, emerging markets have performed robustly overall, supported by structural factors such as high growth, monetary policy, and a weakening dollar."

The movement of the yen is also a key component supporting carry trades. As a traditional safe-haven currency, the yen has not been able to sustain its strength during this geopolitical conflict. The Bank of Japan's relatively accommodative policy stance has allowed its low-interest-rate environment to persist, solidifying the yen's position as the world's preferred funding currency, even as market volatility has significantly increased.

Matthias Scheiber, senior portfolio manager at Allspring Global Investments, pointed out: "Historically, one would expect the yen to appreciate due to safe-haven inflows, but Japan's export exposure and the Bank of Japan's cautious policy stance have instead helped keep the yen weak."

Risks Remain, Duration of Conflict is a Key Variable

Despite the strong performance of carry trades currently, market participants generally emphasize that the duration of the conflict will be the core variable determining whether this strategy can continue.

Noureldeen Al Hammoury, chief market strategist at Equiti Group in Dubai, warned: "If the conflict escalates and triggers global risk aversion, investors typically rush to cover their yen positions to close carry trades, which could lead to a sharp appreciation of the yen and significant market volatility."

Additionally, investors executing carry trades with the dollar as the funding currency have faced losses this month due to the dollar strengthening against most emerging market currencies. According to Bloomberg, Citigroup strategists Dirk Willer and Adam Pickett closed their last recommended emerging market carry positions last week, citing the heightened uncertainty and volatility brought about by the conflict.

Currently, the unusual market patterns created by the conflict still provide a survival space for carry trades, especially as there are no signs of large-scale capital inflows from Japanese investors. However, analysts caution that once market sentiment shifts, the vulnerabilities of this strategy will be quickly exposed